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Continued from page 3

Tilson: We own a two tenths of 1% position in bank of America, so not really. It’s just too uncertain.

Forbes: So you're not like the Fairholme Fund?

Tilson: No. But we're in Citigroup in size. We actually think people sort of lump those two in together. Citigroup's trading at almost half tangible book. Bank of America's trading at about 56% discount to tangible book. So Bank of America’s a little cheaper, but they're both, within a range, the same level of cheapness.

But we like Citigroup a more for two reasons. One is the bad bank part. The way to think about both companies is you've got some good businesses – call it good bank – and then you've got some run-off businesses and some things with uncertain liabilities, etc. – bad bank. Citigroup has, in fact, explicitly structured their business where they have $300 billion, not quite, in assets of bad bank; they call it Citi Holdings. And then there's Citigroup, which is the good bank.

Bad bank is a little more than 15% of assets, but that's all that investors are focusing on. We like Citigroup better than Bank of America for two reasons. One is we think bad bank is less of a black box, has less risks. We feel more comfortable that that isn't going to blow them up.

Forbes: Is that primarily mortgages?

Tilson: About two-thirds of it is U.S. mortgages, both first liens and second liens. Every quarter you can look at the mortgage trends, and all the big banks are sort of kicking the can down the road on the mortgages. But you can't kick the can down the road on what percentage of mortgages missed their first payment and went 30 days delinquent, right? Well, you can actually track that data. The trends have actually been fairly stable – even improving – in bad bank. So that gives us some comfort there. They also have some pretty good assets in there as well, but they're trying to sell or run that off.

But the real reason we like Citigroup better than Bank of America is we like good bank better. Citigroup has a fantastic international franchise – highly profitable. They have something like 40% market share in Mexico, 40% market share in Korea. They generate two-thirds of their profits in high-growth emerging markets.

So, some day, we have to figure that investors will take their eyes off the fixation on 15% of their business and look at the other 85% say, "Hey, this is a heck of a business." And it's being managed fairly well. As they run down bad bank, good bank is performing very well.

So we think if you net out the down side of bad bank and the positives of good bank, it's probably worth tangible book value, which is about $50 a share. And the stock's at $26. So we can make a very nice return, even if it takes two or three years for the market to come to its senses on this one.

Forbes: So in a sense, with Citi, while it hadn't done anything 12 years ago, that's in essence what Citi's going to become again today.

Tilson: Yes. You have to keep in mind there's a stock split in there. So the stock's down about 95% from its peak.

Forbes: No, but I mean in terms of the acquisitions and all of the stuff they did – mortgages.

Tilson: In terms of building, yeah. I think they created something that was very unwieldy and almost impossible to manage and to correctly see risk.

Forbes: Too big to succeed.

Tilson: Yeah. They took on too much risk, and it really blew them up. With the recent retirement of Bill Miller, I was reading an interview with him back in 2005, the last year of his unprecedented streak of beating the market 15 years in a row, when he was riding high. And he was pitching, among other stocks, both Citi and JP Morgan.

Since that time, Citigroup's down 95%, and JP Morgan's down, I think, 20%. So in other words, not all big banks got killed. The big banks that had someone running them – someone that was focused on risk and kept them out of the riskiest things – actually hung in there pretty well. It's sort of remarkable that, almost unique among the big banks, JP Morgan, thanks to Jamie Dimon seeing the trouble coming and positioning the bank differently, was able to weather such a severe storm.

TARP Warrants

Forbes: You bought warrants in the banks a few years back?

Tilson: Well actually, just recently.

Forbes: TARP warrants?

Tilson: TARP warrants, which are very interesting securities. They're hard to buy in size if you're big institutional investors. I think that’s one of the reasons they're cheap. As part of the TARP investments that banks were forced to take, in some cases when banks repaid the money the government got these long dated securities.

I think in the case of JP Morgan, it's dated 2018. So you've got seven years. And they're a bit out of the money – I think it's a $43 strike in the case of JP Morgan. You're sort of buying a very long-dated, moderately, not crazy, out-of-the-money call option. And when we think about where we think this bank will be over a seven year period, it's a very attractive, very leveraged way to take a position. You can tie up a lot less capital. If you're wrong, you lose less capital, but you still have all of the upside if you're right.

Forbes: So you've done that with both Citi and Morgan?

Tilson: Not with Citi. I'm trying to remember which of the big financials have those TARP warrants. I know Wells Fargo does. I believe Goldman retired those warrants, if I recall correctly. The two I know we own right now are Wells Fargo and JP Morgan.

Forbes: And Italian bonds – would you buy Italian bonds?

Tilson: Not in a million years. People talk about how, "Oh, the interest rate's gotten up to 7% and that's going to bankrupt Italy." If you force me to hold them – if you said, "You can buy them but you have to hold them for two or three years," or something like that – I wouldn't buy them if they were yielding 20%. And I don't actually think Italy's going to default.

Forbes: No risk-reward ratio.

Tilson: 7% for something where you're really taking catastrophe risk, not to mention inflation risk I think anyone buying U.S. ten-year Treasurys yielding 2% is certifiably insane, given that the printing presses are running and the U.S. isn't going to default. With inflation actually starting to pick up, that's a terrible investment relative to many other more attractive investments, like blue-chips stocks, in my opinion.

Forbes: Is it 2% because it's a default position? Why would anyone buy it voluntarily?

Tilson: Well, I think as a safe place to park cash Treasurys, short-term Treasurys, are a reasonable place. I scratch my head at the low interest rates investors are willing to accept for ten-year or 30-year Treasurys. I think what explains this market inefficiency – given, I think it's crazy – my best guess is that the large institutional money of the world is managed by people who, it's not their own money and they're evaluated based on monthly or quarterly or certainly once a year performance.

You can only buy stocks and bonds, so your alternative to Treasurys is riskier bonds. Well, that could cost you your job. Or stocks, which are yo-yoing around like crazy. There's a lot of short-term volatility. That could cost you your job as well. So what do you do? You retreat into the default safest investment out there: U.S. Treasurys.

So it's actually logical when viewed from the career standpoint of the people making the money allocation. It's just sort of insane if you're a retiree, or if it's a pool of capital that's going to pay out your retirement or health care benefits in 20, 30 years. Earning 2% in currency, where there's likely to be inflation greater than 2%, that's insane.

Forbes: How much of it do you think is Central Bank-owned? Again, it's not their money.

Tilson: My understanding is China has bought a bunch of it over the years, and they have another structural reason. They're not really buying it as an investment. They have a huge trade surplus with us, they've got to park it somewhere – sort of buy up dollars. So there are some structural inefficiencies.

But for an investor with free will, today, the choice is between buying ten year Treasurys, where you're likely to get a negative real return, versus four companies in the U.S. stock market that have a higher credit rating than the U.S. government. They're all rated AAA by the all the ratings agencies, right?

You've got Exxon Mobil, ADP, Johnson & Johnson and Microsoft. Those four stocks, on average, are trading at 12 times earnings and yielding close to 3%. So you can get a 3% dividend yield and you know the dividend money's good. And none of those companies are going to cut the dividends.

Forbes: Right.

Tilson: You're guaranteed to get 3% a year for the next ten years, just on the current stock price. If you get inflation, all of these companies have pricing power, so you'd figure they can pass along inflation. I think short of a severe Japan-style deflation – which there's maybe a 5% or 10% chance of that over the next ten years – you're overwhelmingly likely to do better in carefully chosen blue-chip equities with a nice dividend yield, where you're not paying too high a multiple for it. Yet the institutional investors of the world are fleeing to 2% Treasurys.

Getting Out Of An Investment Hole

Forbes: Now, you try to do well, obviously, long term.

Tilson: Sure.

Forbes: Is this one of your worst years ever, still, or are things picking up?

Tilson: It is.

Forbes: Worst in your 13 years?

Tilson: This will be our third year out of 13 that we've trailed the market. And we're down over 20% this year, which has been painful and humbling. It's the kind of thing where I wish you hadn't reminded me of it. Because actually, to succeed when you're in a hole – every investor goes through periods where you just have the touch of dirt, I'll call it. The polite word. We'll call it the touch of dirt.

Investing is a probabilistic business. Every once in a while, it's sort of like you're throwing six-sided dice and anything except a one or a two, you're doing well. Statistically speaking, you throw the dice enough times, you're going to throw a one or a two five times in a row, and you're going to look pretty foolish, right?

I think that's mostly what's happened to us over the past year. There's been no single mistake. We didn't pile into financials earlier this year and get killed, or anything like that. It's just sort of been across the board – the playbook that's worked well for us for 12 years just hasn't been working for us.

It's been sort of frustrating and humbling. But the key, actually, when you're in a hole, is you have to mentally pretend that you're flat on the year and that your portfolio's 100% cash. What would you do? Because what really gets you into trouble is when you're in a hole and it's so painful and your investors are mad at you and so forth, that you swing for the fences and you start taking on leverage and buying riskier securities in an attempt to quickly get back out of that hole.

You almost have to wipe your mind of the fact that you're down and feeling bad about it. You just have to approach every day and say, "If you were starting fresh today, what would my portfolio look like?" So that's how we think about it.

Forbes: Now how do you deal with clients? Because their record, like the proverbial individual, is if you're on a hot streak they like you. If you have a few bad years, even though you've had a good long term record and are disciplined and you're not flying all over the place, they abandon you. Whereas research shows it's precisely when we have a cold hand is when a client should come in.

Tilson: Right. Well, as you said, the best time to buy a good company is when it's hit a short-term rough patch and the stock's gotten clobbered. That's very self-serving argument, admittedly, that we make to our clients. That, "Hey, judge us based on our 13 year record, and it's a pretty darn good record."

We basically more than doubled our investors' money net to investors in basically a flat market over almost 13 years. So even after this year's terrible performance we have a good long term record. But the key is we built our business the right way.

We never went after hot money, funds of funds, etc. Our investors are generally upper middle income to high net worth individuals who are investing their own money. And they're people that we communicate with regularly. A lot of our money is just friends and family. So we built our business deliberately to make sure we could withstand a period of poor performance, because we knew that every investor goes through periods of poor performance. You want to make sure that you can play a strong hand and not be forced to sell cheap stocks – but instead can be buying them.

So the good news is we're still standing strong. We're not being forced to sell anything. And were at very minimal redemptions. It would be hard for me to think of any fund I know of out there that would have as bad a year as we're having that would have as few redemptions as we're having. And that's, I think, a testament to our investors and how we've built our business.